Riff based on a comment posted on “imaneconomist”Posted: October 28, 2011
It is simpler than this. It is not a pure matter of economics, but about history and the function of the law. Wall Street walked off with FNMA’s securitization process essentially unregulated because the government wasn’t paying attention. It just let the private sector do what the government had done. Down to the very techniques, the mechanics. The SEC didn’t bother to lift a finger to look with its anti-fraud lens at either Fannie’s activities, or Wall Street’s in replicating Fannie. Yet the securities law requires such scrutiny in anything inherently subject to price manipulation and fraud. I worked in a Wall Street law firm with government connections in the early 80s when the legal community was scoping all of this out. The legal profession was well aware that CDOs and MBS and innovative financial derivatives were securities. The government was also so advised, but, apparently, into a black hole. Lawyers then hastened to help Wall St. evade the the spirit of the securities law by deep sixing any implication that onerous full disclosure, transparency and due diligence was required of them. Regulators were stovepiped in departments set up in the 1930s, reflecting the divisional categories of a simpler day.
The public assumes the government protects it, by virtue of how complicated everything all is, but the flip side of comprehensive complexity is that no one understands it. Bureaucracy drones on by rote. Underpaid relative to Wall Street, regulators need to be at the cutting edge of a changing field, but rarely are. Nor does the private sector care to cue regulators in, lest they come under the spotlight next.
Fannie’s securitizations were originally workable only because (a) Fannie always had strict rules guarding the quality of the loans in the securitization pool and (b) because of the 100% taxpayer guarantee, a promise that only works for the taxpayer if limited to a narrow category. Not expanded to cover anything and everything—and government always tends to replicate itself in the effort to justify its existence. Fannie was conceived as a national insurance monopoly. A development plan to help the US out of the Depression of the 1930s. It was never conceived as a market-based financial institution or operational insurance company. It wasn’t a business, insurance or otherwise, but a government program.
This government process involving securitization couldn’t be just handed over to Wall St., not unless Wall St. got heavy securities law scrutiny. Unfortunately the law tends to be a playground these days for sophists who run about asserting that black is white and 2+2=5. Let’s just say that anything complicated isn’t hard for an unscrupulous and well paid lawyer to tie up in knots for years.
Washington politicians looked only at the promoted upside, not the down—e.g., the magical properties of portfolio diversification. On this rationale, all of banking was allowed to merge and cartelize, starting in the 80s, as banking crises started to happen. As Washington rationalized it, with the aid of soothsaying bank lobbyists, absurdly large banking entities somehow “ensured” against risk, as opposed to creating insanely overlarge and unmanageable conglomerates. They also no longer had any interest in scrutinizing for quality. Quality was random walked out of the room as a consideration. Pooling, like a magic elixir, would meliorate all. Ironically banks imitated Washington, literally, in the sense of that warehouse at the end of the movie Raiders of the Lost Ark, where any toxic waste could be buried, with no one the wiser. Banks to some extent themselves may have been dumbed down by FDR’s securitization gambit to begin with, to become companies looking for the next guaranteed, easy-money paper pushing racket to wangle out of the government. The existence of Fannie meant banks no longer had to be market-disciplined, sharp-eyed lenders scrutinizing debtors for quality. Just machines focused on an algorithmic ticking of boxes, assembly line style. Boring zone-out operations based on a “business model” handed to them by the government, who itself stopped thinking about anything but following the template, decades ago. No longer having skin in the game changed their character. Inevitably, their talents and abilities declined, as their prestige of size, and arrogance over what now seemed magical (US guaranteed) money making skills rose.
Antitrust law was under a cloud for a generation, due to a fad in legal circles. Disparaging antitrust was in vogue due to a few ill-considered judge-ordered breakups and bad dicta in antitrust. But that didn’t mean antitrust and the principle of free markets and competition was dead. To be anti-antitrust became a narrative trope. The fad for deregulation also was misused by lobbyists promoting special interest legislation. Deregulation obviously doesn’t mean total regulatory abdication. Basic government services need to be done competently and in the public interest. Criticism of the government or the private sector is not ad hominem or per se. Regulatory laxity and ditching the public interest is not what deregulation calls for. The revolving door is always a corrupting force in government but the point of government reform is to cut fat, not arteries.
Narrative proclamations of law in no way insures that the stated conclusions will be enforced. At any moment in time government is fully occupied with whatever previous legislators heaped on their plate, and don’t have time for more. Time is money and any new major duty heaped on government, has to be paid for.
Regulators wound up declaring certain assets safe by law. But no asset can be “presumed” safe by “type.” A law declaring certain types of things AAA is a circular tautology, assuming a fundamentally economic conclusion that has to be market tested and now won’t be. Only market actors, not lawmakers, can make market decisions about pricing. And there is a limit to all government guarantees against loss. If the government is the ultimate guarantor, then it is the principal in the transaction, not the putative “private market” firm. FDR understood business better than politicians do today. He strictly limited what the government would guarantee. Washington today copycats FDR’s techniques in its affection for 30s era national insurance schemes. But they don’t follow FDR’s lead in strictly limiting their scope, or the behind the scenes imposition of rigorous rules selecting on a global basis for quality.
Today Congress, from the top, just manufactures moral hazard, merrily, without even recognizing that it is doing so. The basic point is that of the agency problem of economics. The integrity of an investment decision cannot be wholly trusted if the entity making it has no skin in the game. With no skin in the game you have to have absolute trust in their competence, good faith, and integrity. Rarely do such conditions exist. Our politicians are experts in faking it. The government had no basis on which to guarantee super high leverage on specific asset types. Having taken on full responsibility to guard market integrity for the nation, our government is to blame for the failure, but so is their partner, the banks. Today it is Wall Street who is the senior partner in the crony relationship with Uncle Sam. It was the expert in securities law, it must have known all along at some level what it was setting up, and at all points it proved to have no compunction about robbing the US taxpayer, for its own account.